Research, Unbundling and MiFID II

Research, Unbundling and MiFID II

The “soft dollars” question, that is, the issue of the arrangements by which the managers of other peoples’ and other institutions’ money might most appropriately pay for investment-related research, remains unresolved.

Traditionally, the managers of investment funds, alternatives among them, could collect rebates from the trading fees charged them by brokerages, with the idea that they would use this money to pay for the research that would keep them trading.  As a variation, the broker could do the research and share the results, without any money changing hands on this point between firm and broker. Either way, such arrangements came under fire on both sides of the Atlantic, and on both sides of the Channel, early in this century, and no ‘new normal’ has yet come about to replace the old.

A Delegated Directive

On April 7, 2016, the EC published its “Delegated Directive,” a level II measure under MiFID II.

The DD deals with among other points “the provision or reception of fees, commissions or any monetary or non-monetary benefits (inducements).” That language includes, for example, rebates as an inducement to keep trading through a particular broker.

The firms/funds should refuse most such inducements.  The refusal is mandated in order to crack down on self-dealing at the expense of clients. A rebate that the managers can put into their own pockets as a reward for sticking with a sub-par brokerage … a bad idea. So for that matter, in the view of the EC, is a rebate that managers would employ to research the markers. A firm might accept “minor non-monetary benefits.” But the European Securities and Markets Authority (ESMA) has taken the view that tailored investment research cannot fit that bill, and the EC has largely accepted ESMA’s advice.

A brokerage firm can offer as part of its services, and an investment firm as client can accept, “added-value tools, such as objective information tools, helping the relevant client to make investment decisions.” But in such a case they have an obligation to pass the value of those inducements on to their own clients as soon as possible.

Negotiating Explicit Research Charges

The DD encourages the unbundling of research from brokerage services, via a separate research account that may be “funded by a specific research charge to the client which should only be based on a research budget … and not linked to the volume and/or value of transactions executed on behalf of clients.” This sounds like a more conflict-free approach to paying for research than is the acceptance of inducements from brokers.

There is at least one respect in which the DD is more flexible than the advice offered by ESMA. The DD provides that a separate research account established pursuant to such an agreement may be increased after provision of “clear information” concerning the increase to the client. The ESMA advice seemed to be that more than clarity, that a separate explicit written agreement is required.

Brexit notwithstanding, Britain’s FSA has endorsed unbundling.

France? Not so much. L’Autorité des Marchés Financiers (AMF) released a consultation paper on the subject, on September 12.

Those Non-Monetary Benefits

France takes a broad view of what might count as a “minor non-monetary benefit,” and thus allows a fairly large loophole by which firms and brokers may arrange for a firm’s market research at the expense of the latter.

The AMF’s explanation? Insofar as macroeconomic research in particular “has been widely disseminated, it might reasonably be considered that a provider has not allocated specific substantial resources to any given portfolio manager in order to produce it. Consequently, such research constitutes a minor non-monetary benefit which could be received by the investment firm free of charge ….”

Since it is a “non-monetary benefit,” it has to stay non-monetary. So, the AMF says, “the benefit in question … will not be charged to the investment firm by the service provider, and the investment firm will therefore not be able to charge the cost to its own clients.”

What is “Research,” Anyway?

However exactly all this is worked out by the Eurozone, and/or by the Brits, the stress on regulating the financing of research makes it very important that the word “research” itself be defined with care. The AMF defines the word to cover materials or a service that “explicitly or implicitly recommends or suggests an investment strategy and provides a substantiated opinion as to the present or future value or price of such instruments or assets, or otherwise contains analysis and original insights and reaches conclusions based on new or existing information that could be used to inform an investment strategy and be relevant and capable of adding value to the investment firm’s decisions on behalf of clients being charged for that research.”




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One Comment

  1. Thom Young
    February 10, 2017 at 12:07 pm


    Very informative article…you make such a good point about talent reward/retention programs, particularly post 2017 when the old deferral balances are paid out. Talent will become very mobile.

    As I am sure your readers know, due to 457A, hedge fund managers are in a tough spot because unless they use Fund Alignment Rights they have a hard time tax efficiently funding long term incentive or deferred compensation plans.

    FARs are fair market value options on fund shares that are granted by the fund to the management company in lieu of an annual cash incentive fee. FARS are not taxable to the manager until the manager chooses to exercise its options. FARs give the manager the ability to build a pool of pre tax retained earnings (option spread) to exercise as taxable income as needed (bonus time). Investors should appreciate the head to toe alignment FARs offer since the incentive fee accrues from the fund to the management company, and then back to back from the management company to the Employees since future bonuses are tied explicitly to fund performance.

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